Europe: shift to expansionary fiscal policy?

29 February 2012

This piece makes a series of predictions, many of which will probably turn out to be false, but from where I am, I cannot see how the course of austerity currently pursued in Europe could continue for much longer. Like previous articles on economics and politics, I claim ignorance on many aspects, not proffered as an excuse, but rather as a warning, and I write in an extremely generalized and vague way. The central thesis is: I believe that in the time period between now and late 2013, there will be a general shift in European economic policy, that will move from measures of austerity to expansionary fiscal policies. This will involve both general policy discourses as well as events that will be remembered as various turning points.

The current sovereign debt and deficit issue will continue for some time, so it seems somewhat counter-intuitive, but there will be a new president in France this year, and a new government in Germany by October 2013, and there will be many competing political narratives vying for the support of the populace. The Franco-German axis is and will remain crucial in maintaining the eurozone, and both sides know that there has to be a unity between these two countries, otherwise the eurozone and possibly the EU as a whole can disintegrate. Political events and personalities will change the tone and directions, though within the pretty narrow corridor of manouvrability determined by the larger economic factors. Somewhat oddly, what matters is not the personnel as such, but that there are these elections, events if you like, that will make such a change in the course of policy both desirable and perhaps necessary from political perspective. In other words, whoever wins, there will be a shift in policy.

The French presidential election is likely to be pretty close, and probably much closer than it is expected, provided both Mr Hollande and Mr Sarkozy make it to the second round. Recent opinion polls suggest that the gap between Mr Hollande and Mr Sarkozy has narrowed, and Ms Le Pen has fallen behind. If Mr Hollande were to emerge victorious, the emphasis on austerity will be less pronounced. Mr Hollande does not seem to be a tax-and-spend, spend-your-way-out-of-recession sort, but taxes will go up for the wealthy, and cuts mitigated. Even if Mr Sarkozy were to win, it is doubtful that he will continue down the path of severe fiscal contraction.

Unless some sort of political miracle happens, the FDP, the junior coalition parter to Chancellor Merkel’s Union parties, will be lucky to garner 5% of the votes necessary to be back in the Federal Parliament. The FDP has suffered one humiliation after another in the state elections that took place in 2011: the final ignomy was dealt in Berlin, where the party came not only behind the Social Democrats, the Christian Democratic Union, the Greens, and the Left, but also behind the Pirate Party and the far-right NPD. As there are more than one-and-a-half years to go until the election, it’s impossible to say what the outcome will be, and which parities will obtain what proportion of the votes and seats, but it looks extremely unlikely that the current black-yellow coalition will be back in power. Even if the Union parties (CDU and CSU) were to form the largest parliamentary group, their coalition partner will likely to include either the Social Democrats or the Greens, and neither party is an enthusiastic proponent of austerity.

As indicated earlier, the issues of sovereign debt, deficit and credibility will remain with Europe in general and with European states in particular for some time to come. Both debt and deficit need to be reduced, however, of the two, deficit is more important, in that so long as there is a deficit, the debt will continue to rise. Measures of austerity are necessary, however, austerity can strangle economic recovery, as expenditure increases due to rising need for social welfare, and tax revenue decreases as more people are unemployed and businesses suffer. The economy slides into a negative spiral that is deflation. Austerity is a necessary but not sufficient condition for economic recovery. Indeed, it may perhaps be argued that austerity needs to be followed by expansionary fiscal measures. If structural deficit can be brought under control, then it would be far easier to argue for expansionary policy for investment rather than propping up a failing system.

With the Republicans in the US doing their best, as it looks from the other side of the Atlantic, to tear themselves apart in an increasingly fractious and bad-natured primaries, and the economy gingerly recovering, President Obama has a strong chance of being re-elected. The US has been pursuing expansionary fiscal policies, partly because it’s been necessary, but also largely because it can. And if President Obama were to be re-elected, it is likely that this policy will continue. Despite the huge amount of public debt, the US can go on printing money, and also keep on borrowing at a reasonable rate, in contrast to many European states. However, the likes of Germany, northern European states in the single currency, and to a slightly lesser extent France, retain the credibility in the eyes of the markets, and as long as German reluctance is overcome, the ECB can fire its broadside by printing money, not just lending cheap money to the banks, which is a more reactive policy than a proactive one, and the eurozone can agree to issue bonds, not to bail out banks or countries, but to fund infrastracutre and other projects to start recovery.

Once it becomes clear that the deficits in the eurozone countries are brought under control, which would take a couple more years, then the calls for more interventionist, state-led recovery will become louder, and it will be popular with the voters. One of the preconditions for this may be the exit of Greece from the eurozone, and its bankruptcy and default on debts, orderly or otherwise: the Greek tragedy that is currently unfolding is a structural failure in the economy and the state, and other eurozone states seem to have run out of patience and lost trust in the ability of Greece to come out of it, even with the successive bailout packages. Portugal has quietly been implementing pretty severe measures, and new governments in Italy and Spain seem to have gained the confidence of the other states, as well as the markets. Greece, on the other hand, has remained the Achilles’ heels, or to use a phrase that has been uttered, a bottomless pit, for the eurozone, and calls for its ejection will probably become louder, especially if it can be reasonably argued that the expulsion of Greece will not lead to destabilization and a general loss of confidence in the euro. However, this is a bleak news for Greece: leaving the single currency, or for that matter, a unilateral default, is unlikely to be a panacea for the Greeks.